’Lion’s Share Of Funds Will Go To China’

Though the global fund-raising environment is improving, it is not completely out of the woods yet and LPs (or investors in private equity) are still leaning towards China when it comes to an Asian presence. In an interview with VCCircle, Jennifer Choi, Director Research, Emerging Markets Private Equity Association (a non-profit global industry association that represents VC/PE investing in Africa, Asia, Europe, Latin America and the Middle East), who is currently preparing a research note on India, talks about India vs China, ground realities on fund-raising and the challenges playing out for India. Excerpts:-

Where does India stand from a risk-return perspective on the LPs’ (investors in PE) radar?

LPs continue to have interest in India. The tension for a lot of them (LPs) is choosing whether to go the China, India or the pan-Asian fund way when they think of getting an Asian exposure. There is a transgression from regional funds towards country-dedicated vehicles. So LPs appear to be taking interest in China-dedicated or India-dedicated vehicles. But the other dimension is for the pan-Asian fund. It’s expected that from an Asian fund raising perspective, China will continue to capture the lion’s share. The share going to India-dedicated fund will continue to be significant but may not be entirely represented by India-dedicated fund-raising. This is because investment is coming out of these regional vehicles as well as from global platforms where there isn’t a dedicated Asian fund. For example, KKR and Blackstone that are looking at India and other markets but not necessarily with a dedicated geographic mandate.

Both China and India are growth markets. Then, why is China attracting a lion's share of investments? What are the concerns playing out for India?

It’s hard to talk about LPs as a homogenous class but there is a general assumption about the psychology of LPs that they follow a bit of a herd mentality. So if there is a general sentiment in the market that China is the place to be and I think every conference, media interview and report about PE tends to emphasize China, it’s not unreasonable for LPs to pick up on them. LPs are looking where they are going to get the largest domestic growth. There is real deepening of domestic growth drivers there.

India has that as well but for LPs, as they become more familiar with India, what we are hearing is that the legal structure is India is so developed and complex that if you get into a point of litigation you may be there for a while. So while there is extensive opportunity, as in the consumption in India and the creation of products and services aimed at the middle class consumer, the challenge is that the companies within India themselves are at least somewhat constrained in growth by limitation of infrastructure.

Does that create more room for infrastructure focused funds in India?

Absolutely, this is something that many GPs are looking into. But, the challenge is in capturing it in a way that maximizes returns and minimizes risks. There are number of respected PE firms in India. Among them there are many specialized investors in this space and they have figured a way to do that. It’s often not necessarily infrastructure projects which are massive in costs but also infrastructure related sectors. There is still a shortfall in infrastructure investments in India and the government must play a role in that. PPP looks promising but lot of investors are still waiting for concrete results and there is lot of uncertainty.

How is the current fund raising environment shaping up?

Currently, it’s warming up but we are not where we were 2-3 years ago. So conversations are little more fruitful. GPs (fund managers) have managed to strike conversation with LPs even throughout this slowdown, but it’s just that LPs were not able to make this commitment. As equity markets have stabilized, we are beginning to see the LPs make commitments, as now they have greater visibility in the value of those portfolios. And when you look at US investors, many of them who had not previously invested in alternatives had a large portion of their overall allocation to the equity market so the volatility clouded their ability to project cash flows and the ability to commit to funds. The other challenge was that they had lot of uncalled capital that was previously committed to very large funds. And, so for LPs, who want to make new commitments, they are not completely out of the woods but they have lot more clarity about the underlying value of their portfolio and clear sense of what cash flows might be going to the funds to which they have already committed.

What are the trends you are observing in the Indian PE market particularly in the light of emergence of a crop of new GPs?

We have heard what feels like really aggressive estimates on the number of GPs in India. There is nothing to stop a group of partners to start a PE fund.  As there are more and more teams spinning out, LPs are looking to make sure those teams are incentivized to keep them for long term. Another thing we are seeing globally is commitment from higher management. So the GP commitment to the overall fund, I don’t know what it had been in India till 2009, but in US, it was around 1-2 %. Now there is a push for 2% or more.

How are LPs behaving in the current environment? Do we see the balance of power shifting to GPs soon?

LPs are being more organized. They are sharing more information within the LP community. The terms they are expecting, some call them return to normal. This is where the world was 10 years ago before the PE boom. So the question is how sustainable is this phase. It’s very reasonable to expect that power will shift to the GPs but if that’s the case then our expectation is that it would be market specific. If you see lot of interest grow in China, Brazil or India, the more interest there is the more aggressive or more GP-favorable the terms can be.

PE funds globally have not been able to demonstrate consistent ability to outperform the asset classes. If you see the performance information that is available, you see a large gap between the top and bottom quartile.  But what that means for that PE fund manager (in the long run) is evaluated against what an LP can get with equity investments in that same market. As far as where our industry goes into specific parts of the world, it’s really going to be a function of how quickly LPs can recover their portfolio strength because the hits that they suffered is hard and there is not full appreciation of that fact yet. We have not seen full recovery in LP portfolio. We haven’t seen the distributions that one would hope. What will be those distributions is a question of time but GPs will be measured by what they deliver relative to other asset classes where LPs can put their money.

How are the ILPA principles coming into play in those agreements?

ILPA principles are not coming in as a barrier or hurdle because a lot of LPs in emerging markets are already doing many of these things. The general consensus is that alignment of interest problems have been less pronounced in emerging markets than in developed markets. The relevance of the Principles for EMPEA funds may lie more in fund governance and disclosure practices though LPs will doubtless continue to seek more aligned economics.

The GPs in these markets were approaching the interest of LPs from an alignment perspective but I think where ILPA principles are having greater factor of change on the terms of the partnership agreement is probably in those markets where the economics are beginning to strain the margins (funds are being realized at larger sizes, charging fees of 2% are beginning to sound unreasonable to LPs. To go from 5 to 10 billion dollar fund and expect to continue to extract 2% fee, some LPs find that economically painful. And so that’s probably where the changes are happening frequently).

For emerging markets, the concerns remain like those of the repayment of clawback gross of tax, the fixing of fees based only on expenses and the rear-ending of carry to the team.  The issue of net versus gross on tax is important particularly in the case of India because GPs face a difficult time getting tax refunds from the authorities. A pre-tax clause puts a heavy obligation on the GP.

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